PrefBlog

There is one problem with directing tax revenue to debt reduction: it means you can’t spend it. EU plans are running into roadblocks:

Greece joined Italy in objecting to annual numerical debt-reduction targets in a fresh challenge to the German-led drive for tougher economic safeguards to underpin the euro.

Greece, the first deficit-riddled euro country to fall back on financial aid, says the proposed rule would force it to make impossibly large cuts once its support package runs out in 2013, according to a draft of European Union legislation.

“All member states except two already accepted the proposal,” said an EU briefing note obtained by Bloomberg News before next week’s debate among finance ministers. “Italy and Greece have a reserve on the numerical benchmark.”

Greece or Italy alone could veto the rule, undercutting the tougher enforcement demanded by Germany as a condition for beefing up the 750 billion-euro ($1 trillion) rescue fund for distressed states.

Assiduous Readers will remember it was France and Germany who scuttled the 3% deficit rule when it was no longer convenient to them.

The Fannie & Freddie problem is lurching towards the limelight:

U.S. Treasury Secretary Timothy F. Geithner presented Congress with a set of options for weaning the $11 trillion mortgage market from its dependence on the government, while calling for changes to be phased in “responsibly and carefully” to avoid economic disruptions.
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The options suggest differing degrees of government involvement in the system. The most dramatic would involve a “privatized” system of housing finance, with a government role to help “narrowly targeted” low-income and veteran buyers.

A middle ground would replace Fannie and Freddie with a system that helps low-income and veteran buyers in normal times and also provides an expanded guarantee that the government could ramp up in a crisis. The paper suggests using high-priced guarantee fees or restricted amounts of public insurance to achieve this goal.

A third option has the biggest government role and would hew closest to the current system. It would impose more regulation and give the government a role in “catastrophic reinsurance behind significant private capital,” so as to provide a backstop in times of crisis.

We have a wee bit of xenophobia happening:

Ontario Finance Minister Dwight Duncan has turned up the heat in the political debate surrounding the proposed transatlantic stock-exchange transaction, saying he does not want a “strategic asset” owned by the Middle East.

“We do business with the Middle East,” Mr. Duncan told reporters at Queen’s Park on Friday. “I am just not sure I want them owning our stock exchange.”

Then buy it yourself – jerk. He doesn’t even have the “finite natural resource” excuse. Seems to me that if a foreign-owned TMX stops doing its job properly, then there are a few Alternative Trading Systems that would be pleased to pick up the slack. Or somebody will write the code to start up a new one. But I guess Duncan thinks Canadians are too stupid to do that.

It was a quiet day on the Canadian preferred share market, with PerpetualDiscounts up 1bp, FixedResets down 6bp and DeemedRetractibles gaining 5bp. Volatility was small and volume was muted.

There’s always a new wrinkle:

ETFs have emerged as a possible mechanism for maximizing gains in one stock while potentially masking trading patterns, people familiar with the matter say.

In one scenario, a trader could learn information about a company, buy an ETF that includes the company’s stock, and short sell the other stocks in the ETF.

The practice, known as ETF-stripping, would allow the trader to benefit from movements in the company’s share price without directly buying or selling that stock.

It was a good day in the Canadian preferred share market as PerpetualDiscounts gained 4bp, FixedResets were up 2bp and DeemedRetractibles leapt ahead by 21bp. Not much volatility, with ony four entries on the Performance Highlights table. Volume remained well above average.

Choose your partners! Now it looks like Deutsche Bourse will purchase Euronext:

Deutsche Boerse AG is in advanced talks to buy NYSE Euronext in an all-stock transaction that would create the world’s biggest exchange operator, accelerating a day of takeovers that began with London Stock Exchange Group Plc’s acquisition of TMX Group Inc.

NYSE and Deutsche Boerse said they will produce 300 million euros ($410 million) in cost savings, according to a statement. Duncan Niederauer, New York-based NYSE Euronext’s chief executive officer, will hold the same job at the combined company. Frankfurt-based Reto Francioni, CEO of Deutsche Boerse, will be chairman. Deutsche Boerse will own about 59 percent to 60 percent of the joined corporation.

A new generation of Goldman Sachs guys has learned a lesson:

Goldman Sachs was “buying more illiquid assets than we probably should have,” Viniar, 55, said today at a conference in Miami hosted by Credit Suisse Group AG, his eighth consecutive appearance at the annual event. “It was a good lesson learned.”

“Less liquid assets” increased at a 39 percent compound annual growth rate between the start of 2005 and the start of 2008, compared with 24 percent growth in liquid assets, according to a slide Viniar included in his presentation. Since the first quarter of 2008, the firm has reduced holdings of such investments at an 18 percent compound annual rate, while liquid assets are down 9 percent.

The assets included mortgage-backed and other asset-backed securities, loans, high-yield debt, emerging-market stocks and bonds and investments in funds and private equity, the slide showed. They totaled $172 billion in the first quarter of 2008, or 14 percent of the firm’s balance sheet, up from $65 billion, or 11 percent, three years earlier.

An IMF report titled IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07 bears the message:

This evaluation assesses the performance of IMF surveillance in the run-up to the global financial and economic crisis and offers recommendations on how to strengthen the IMF’s ability to discern risks and vulnerabilities and to warn the membership in the future. It finds that the IMF provided few clear warnings about the risks and vulnerabilities associated with the impending crisis before its outbreak. The banner message was one of continued optimism after more than a decade of benign economic conditions and low macroeconomic volatility. The IMF, in its bilateral surveillance of the United States and the United Kingdom, largely endorsed policies and financial practices that were seen as fostering rapid innovation and growth. The belief that financial markets were fundamentally sound and that large financial institutions could weather any likely problem lessened the sense of urgency to address risks or to worry about possible severe adverse outcomes. Surveillance also paid insufficient attention to risks of contagion or spillovers from a crisis in advanced economies. Advanced economies were not included in the Vulnerability Exercise launched after the Asian crisis, despite internal discussions and calls to this effect from Board members and others.
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The IMF’s ability to detect important vulnerabilities and risks and alert the membership was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed. The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.

There will doubtless be some who find it surprising that Holy Regulators are no less fallible than Evil Bonus-Hunters.

It was a mixed day in the Canadian preferred share market, with PerpetualDiscounts basically flat, FixedResets gaining 15bp and DeemedRetractibles down 1bp. Volume was heavy.

PerpetualDiscounts now yield 5.61%, equivalent to 7.99% interest at the standard equivalency factor of 1.4x. Long Corporates now yield 5.6%, so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 240bp. Note that this figure is not really comparable to anything that has ever been reported here before: it seems fair to speculate that recent figures have been pushed downwards by speculation that banks’ (and, perhaps, eventually, other regulated issuers) PerpetualDiscounts would have their call probability determined by other than economic factors – as has in fact happened. With the recent transfer of these issues to the DeemedRetractibles index, the PerpetualDiscount index has had its composition changed dramatically: it is now comprised of two layers of a single conglomerate (PWF and POW, 9 issues), utility-equivalents (W, CIU and FTS, 4 issues) and a thing-a-majig (BAM, 2 issues).

There is talk of a merger between the TMX and the London Stock Exchange:

London Stock Exchange Group Plc is in advanced talks to purchase TMX Group Inc., owner of the Toronto Stock Exchange, to create the world’s eighth-largest exchange operator by market value.

LSE plans to issue stock according to a ratio that is similar to the companies’ relative market values, according to e-mailed statements. LSE would control 56 percent of the combined entity given its market capitalization of 2.42 billion British pounds ($3.89 billion) and TMX’s C$3 billion ($3.01 billion), according to data compiled by Bloomberg.
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The exchanges will have headquarters in London and Toronto and maintain their current regulators, according to their e- mailed statements. Management of the merged company will be drawn from “a balance of leaders from both organizations,” the statements said.

Trading of TMX Group was halted, according to exchange data sent at 4:24 p.m. Toronto time today. The company is scheduled to report quarterly financial results tomorrow.

The guy who owns The Tea Emporium in First Canadian Place must be ecstatic.

DBRS has commented on the SEC’s Credit Rating Standardization Study:

This provision requires the Commission to study the feasibility and desirability of standardizing credit rating terminology and standardizing and streamlining certain quantitative measures under four broad topics.[Footnote] Within one year of enactment of the Dodd-Frank Act, the Commission must submit to Congress a report containing the findings of the study and the Commission’s recommendations, if any, with respect to the study.

DBRS suggests that credit rating standardization is neither desirable nor feasible. In short, DBRS endorses the views expressed by the American Securitization Forum on this matter.

Footnote: The four broad areas are: (1) standardizing credit ratings terminology, so that all credit rating agencies issue credit ratings using identical terms; (2) standardizing the market stress conditions under which ratings are evaluated; (3) requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations under standardized conditions of economic stress; and (4) standardizing credit rating terminology across asset classes, so that named ratings correspond to a standard range of default probabilities and expected losses independent of asset class and issuing entity.

I haven’t been following this at all, but the whole project seems ill-advised to me at first glance. As an investor, I want a broad range of opinions, particularly in relation to market stress and economic stress. The whole point seems to be to quantify your guesses down to four decimal places; the type of project beloved of bureaucracy.

Robert Shiller doubts the ‘better living through better regulation’ story:

Robert Shiller, the Yale professor who correctly predicted the 1987 stock market collapse and the recent U.S. housing market meltdown, said Canada’s robust financial health compared to other nations is largely due to a random run-up in oil prices in the midst of the global financial crisis.

“It’s a major export for Canada and it went to US$140 a barrel in 2008, right when Canada needed it,” Prof. Shiller said in an interview Tuesday.
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“It seems that if the country didn’t have that boost from oil, it would have done worse than the United States,” Prof. Shiller said.

The market came down a bit after yesterday’s euphoric response to the OSFI ruling, with PerpetualDiscounts flat, FixedResets down 29bp and DeemedRetractibles down 31bp. Volume was heavy.

The SEC Flash Crash Advisory Committee has been discussing the Flash Crash for some time now; speculation is intensifying:

Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.

“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.

“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”
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“Given the potential for trading algorithms to cause severe trading disruptions and shake investor confidence, we also are considering whether they should be subject to appropriate rules and controls,” she said.

One committe member is floating trial balloons:

Robert Engle, a Nobel Prize-winning finance professor at New York University, said in an interview that the regulator-appointed panel has not yet decided on its final recommendations, though he expects them to be made public at a February 18 meeting.

The focus, he said, should be that buyers all but vanished during the May 6 market plunge, abandoning investors when liquidity was most needed.

This could be fixed by allowing exchanges to boost the rebates it pays for standing buy and sell orders, and by squeezing more of the trading that takes place in anonymous “dark pools” into the public markets.
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Engle said he has pushed for rules that would come into effect when markets are under duress and in need of more liquidity, allowing exchanges to boost both the rebates they pay for orders as well as the fees they charge traders.

“You would have a peak-load pricing model, much like the way you use peak-load prices to adjust traffic across a bridge or freeway,” Engle said in a telephone interview from NYU’s Stern School of Business.

In discussions with a four-member subcommittee, the professor has also recommended a move seen for years by many in the industry as far more radical: a “trade-at” rule.

Such a rule would prohibit any of the dozens of U.S. venues and wholesale market makers from executing an incoming order unless it was already publicly displaying the best bid or offer in that particular stock, or unless it improved the price by a set amount.
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“The big banks that are internalizing their trades obviously would hate it,” Engle said. “But basically they already had this captive audience of relatively high quality trades that, it seems to me, ought to be part of the price discovery process,” which primarily takes place on the public exchanges such as the Nasdaq Stock Market.

In other words, trading information has now become a public good. I’ll have more to say about this sometime latter – because a CSA/IIROC discussion paper says the same thing. Back to Engle…

In a September 30 report that serves to inform the committee’s recommendations, the SEC and CFTC said a single $4.1-billion futures sale sparked the crash, and that it was exacerbated by computer-trading programs rapidly offsetting positions, and by the crush of sell-now orders.

While “Sunshine” laws have prevented the committee from regularly meeting, Engle said the subcommittee has discussed a bevy of sometimes esoteric market structure issues:

They include excessive quote traffic, trading curbs known as limit up / limit down, a record of all trading known as a consolidated audit trail, restrictions around unfettered “naked” access to markets, and co-locating computers next to exchanges. They also include high-frequency algorithmic trading, he said.

Still, there has been “very little” communication among the full, eight-member committee in the last few months, Engle added. “We haven’t had as much communication as would be desirable.”

The first paragraph seeks to promulgate the mythology that High Frequency Trading exacerbated the Flash Crash, which is a very difficult position to justify. I have taken the view (see the October PrefLetter) that the Flash Crash was merely a case of Market Impact writ large: a single trader sparked it and it was exacerbated not by HFT, but by morons’ Stop-Loss orders.

The bit about the Sunshine Laws makes me laugh!

Here’s an interesting, if self-interested, admission:

Over the past two years, the Bank of Canada, in partnership with OSFI, has developed a stress test that has been applied to all the banks.

Rather than relying on the banks’ own internal tests, OSFI and the central bank have created a “macro” test, White said, adding that the work has put this country at the forefront of such testing.

Some analysts argue some of the results of Canadian bank stress tests should be made public in the interests of transparency. But according to [OSFI Assistant Croupier Mark] White, such public disclosure puts pressure on regulators to present institutions in the best possible light.

Fabulous Fab’s defence against SEC charges continues to grind along:

The Goldman Sachs trader is still fighting SEC litigation alleging he failed to tell investors in the Abacus CDO that hedge fund Paulson & Co. had helped pick out some of the underlying securities and planned to bet against them.

So, Fabrice Tourre is now demanding that Royal Bank of Scotland, hedge fund Magnetar and monoline ACA Capital produce documents relating to the case. And which, he argues, might help him refute the SEC’s claim that companies like ACA wouldn’t have participated in Abacus had they known of Paulson’s involvement.

There was a certain amount of excitement on the Canadian preferred share market today as OSFI’s refusal to grandfather extant Tier 1 Capital reverberated through the market. PerpetualDiscounts were up 30bp, FixedReset lost 13bp and Deemed-Retractibles gained an impressive 110bp.

Deemed-Retractibles? Those are the Straight Perpetuals (both PerpetualDiscount and PerpetualPremium) issued by BMO, BNS, CM, ELF, GWO, HSB, IAG, MFC, NA, RY, SLF and TD. I have added a hardMaturity entry to the call schedules for these issues, at par, effective 2022-1-31.

Who deems them to be retractible? Me. Who chose the issuers included in the list? Me. Who chose the hardMaturity date? Me. I will discuss and attempt to justify my analytical approach to this paradigm shift in the February PrefLetter, scheduled to be prepared as of the close this Friday, February 11, and made available to clients prior to the opening on February 14.

Similar entries have been made to the call schedules of FixedResets from these issuers, but I didn’t bother creating a new index since the overwhelming majority of these issues were overwhelmingly likely to be called anyway, with or without the advisory.

Note that since a REORG_TERMCHANGE entry type causes the analytics to discard prior trading data, all of the reported average volume figures have changed dramatically.

It’s not a bug, it’s a feature!

The Securities and Exchange Commission today charged three AXA Rosenberg entities with securities fraud for concealing a significant error in the computer code of the quantitative investment model that they use to manage client assets. The error caused $217 million in investor losses.
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The SEC’s order instituting administrative proceedings against the firms found that senior management at BRRC and ARG learned in June 2009 of a material error in the model’s code that disabled one of the key components for managing risk. Instead of disclosing and fixing the error immediately, a senior ARG and BRRC official directed others to keep quiet about the error and declined to fix the error at that time.
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The SEC’s order further found that ARG, BRRC, and ARIM made material misrepresentations and omissions about the error to ARIM’s clients. The firms failed to disclose the error and its impact on client performance, attributed the model’s underperformance to market volatility rather than the error, and misrepresented the model’s ability to control risks. BRRC did not have reasonable compliance procedures in place to ensure that the model would assess certain risk factors as intended.
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“Quant managers must be fully forthcoming about the risks of their model-driven strategies, especially when errors occur and the models don’t work as predicted,” said Bruce Karpati, Co-Chief of the Asset Management Unit in the SEC’s Division of Enforcement.

The Bank of Canada has released a working paper by Jason Allen, Robert Clark and Jean-François Houde titled Discounting in Mortgage Markets:

This paper studies discounting in mortgage markets. Using transaction-level data on Canadian mortgages, we document that over time there’s been an increase in the average discount, along with substantial dispersion. The standard explanation for dispersion in credit markets is that lenders engage in risk-based pricing. Our setting is unique since contracts are guaranteed by government-backed insurance, meaning risk cannot be the main driver of dispersion. We find that mortgage rates depend on individual, contractual, and shopping market characteristics. There is also an important amount of unobserved heterogeneity in rates, which could be attributed to search costs.

An Assiduous Reader directs me to a blog post titled The Absurdity of Making Brokers Into Fiduciaries:

The job of a broker is to sell product, that’s it. Somewhere along the way the public came to think that the broker’s job was to make them money. No, it never was. The job of a broker is to choose investments suitable for a client based on their risk tolerance, other security holdings, financial situation, including income and net worth, financial needs and investment objectives. That’s it. Nowhere does it say that the broker must act in the best interest of the client. And there’s a great reason for that.

As I said, it is not the broker’s job to make money for the client, his job is to give the client information on the asset and allow the client to make the decision. In my mind the suitability stuff shouldn’t even exist, brokers should be able to sell anything to anyone, because all they are is salesman. If you think your broker is anything but a salesman, think again. His job is to collect a commission. Now, if he gets you to stick around, trade more, and spend more on commissions by picking the right stocks at the right times, good for him. But to say that is his job, to say he should be held liable for acting in your interest, would be asinine.

Fortunately investors have the option of being serviced by portfolio managers – but most PMs are just jumped up stockbrokes anyway, so it doesn’t make as much difference as I thought it did ten years ago.

It was a mixed day on the Canadian preferred share market, with PerpetualDiscounts up 28bp and FixedResets losing 2bp. The Performance Highlights table is all positive, all PerpetualDiscounts and all insurers, which is kind of interesting. Volume was on the light side.

The decision by OSFI to eliminate, rather than grandfathering, extant Tier 1 Capital means Monday will be chaotic. Brace yerselfs!